The
Case of the Disappearing Profits
Author
Paul Beretz
Daniel Dapper, a dynamic salesman
with limited financial expertise, founded
LIV-HI INC., a CA corp. in 1997. While his
profit margins were thin, the business grew
to $100,000 monthly sales by the by the latter
part of 2001. In December of that year, Mr.
Dapper began an expansion program designed
to produce an increase of 50% in sales with
all expectations of getting his business to
a very profitable level.
The program he had outlined
gave immediate results. Sales increased dramatically
from $100,000 in December to $150,000 by January
2002. As indicated in the very simple summary
income statement below (also known as "operating
statement" or "profit and loss statement"),
the higher revenue generated $15,000 in earnings
the first month:
LIV-HI Inc., Cash Flow
1/1/01-1/31/01
|
Sales
|
$ 150,000
|
|
Cost of Sales
|
(105,000)
|
|
Gen. & Admin.
Exp.
|
(30,000)
|
|
Net Income
|
$ 15,000
|
However, Dan Dapper (known as "Dandy"
to his friends) was not in a position to enjoy his success.
While the company showed profits, the big jump in sales
lead to a $25,000 cash flow deficit. By the end of January
2002, the company was out of cash.
Note:
1. The cash flow deficit was not the result
of any unusual event - it developed from the
relationships that would impact Dan's cash
flow.
2. The deficit was a surprise to the owner
(and maybe creditors?). He thought that a
profitable operation meant positive cash flow.
What is more important - profits or cash flow?
What Mr. Dapper forgot was that
the income statement is an accrual statement
- it records sales when they occur, not
30 days later, when the business collects
the accounts receivable. In addition, expenses
are accrued as incurred, although a company
may pay those obligations later. Some expenses,
such as depreciation and amortization of prepaid
items, represent prior cash payments and this
even adds more mystery (smoke) to the picture
of cash flow - to creditors and the owner.
What Dan Dapper should have recognized in
his cash flow is that:
1. A/R, the only source of cash for LIV-HI
Inc., may turn (or may not turn) in an average
of 30 days.
2. Dan bought $105,000 in inventory in December
to meet January's sales forecast and to maintain
its credit rating, they had to pay in 30 days.
3. Dan pays all operating expense as incurred,
with non-accrued for payment in the following
month.
So with these facts in mind, Dan's projected
and actual cash flow for January would be
LIV-HI Inc., Cash Flow 1/1/01-1/31/01
|
Beginning Cash (in bank)
|
$ 10,000
|
|
Collections (Dec. sales)
|
100,000
|
|
Operating Expenses
|
(30,000)
|
|
Payments (December purchases)
|
(105,000)
|
|
Cash shortage
|
$ (25,000)
|
Conclusion: What appears to be a $15,000
profit for the month of January is a $25,000
cash flow deficit. The $40,000 difference
emphasizes the difference between accrual
and cash accounting.
Solving the Mystery:
Dan Dapper could have filled the funds gap
with external financing, additional investment
or accelerating collections of accounts receivable.
What is the Moral of the
Story? Credit managers beware: look for
the "hidden card," the smoke, the
mirrors: watch the flow of cash!
|
